Compelling Convertibles: A Soaring Bond ETF (CWB)

Heading into 2017, expectations were in place for multiple interest rate hikes by the Federal Reserve, prompting some bond market observes to speculate that a jump to 3% for 10-year Treasury yields would spell the end of the multi-decade bond bull market.

Rising interest rates do not damage all fixed investments. Some bonds can even thrive during rising rate environments, including convertible debt. As the name implies, convertible bonds are corporate bonds that can later be converted into equity in the issuing company. The SPDR Bloomberg Barclays Convertible Securities ETF (CWB) makes investing in convertibles easy for any investor.

In what can be interpreted as a sign bond market participants are expecting interest rates to rise, CWB was one of 130 exchange traded funds (ETFs) to hit 52-week highs last Friday. That brought CWB's year-to-date gain over 4% and its 12-month surge to nearly 23%.

CWB celebrates its eighth birthday in April and in its nearly eight years on the market, the ETF has affirmed the notion that convertibles are usually one of, if not the best, performing corners of the bond market during rising rate environments. For example, the convertible ETF surged 20.5% in 2013, the year of the “taper tantrum,” while traditional, longer-dated bond ETFs, such as the iShares 20+ Year Treasury Bond ETF (TLT) posted double-digit annual losses.

Convertibles are advantageous to issuers for multiple reasons, including lower borrowing costs. Additionally, companies that need to raise capital can issue convertibles instead of equity, avoiding the negative headlines and potentially lower share prices often associated with dilutive new share offerings.

For investors, CWB and convertible bonds are like nearly every other security in that there is no free lunch. While convertibles as an asset class help investors mitigate interest rate risk, that advantage comes with some baggage, mainly some credit risk. For example, more than two-thirds of CWB's 95 holdings are rated below Baa or not rated at all. That is the price investors must pay to access an ETF where about 52% of the holdings have maturities of no more than five years.

There are certainly larger bond ETFs on the market and CWB has some rivals, but it is not small with over $3.1 billion in assets under management and it is the bellwether among convertible bond ETFs. Last year, investors poured over $517 million into CWB. To start 2017, CWB is either seeing profit-taking or diminishing interest rate expectations as investors have yanked $54.5 million from the fund.

Another perk: CWB charges just over 0.4% per year, which is well below the fees investors will find on actively managed convertible funds. Many of those funds cost 1% or more per year, underscoring a decided advantage for CWB in long-term portfolios.